The Next Bubble

A wise man (whose name escapes me) said that burst bubbles do not re-inflate. For proof, please look at the NASDAQ and the Tokyo Stock Exchange now as compared to their all-time highs. But that doesn't mean that new bubbles aren't looking form all the time. For the record, the current housing price declines has less to do with the few subprime borrowers that defaulted and more to do with a world reawakening/reacquainting itself with credit risk coupled with funding/liability mismatches (using CP to finance long-term obligations, the carry trade). Many pundits are serving up Emerging Markets as the new bubble candidate. They certainly qualify. Investments pushing to succession of new highs driven by investors trying to eke out any sort of incremental return. Over the past two months, there were many people calling emerging markets the "safe haven" from the credit market turmoil, Russia, now nine years out of bankruptcy, in particular.

Are the emerging markets the safe haven? It boils down to two very fundamental arguments. The first is no, that credit risk has not been repriced and reevaluated in those markets. The second in the new paradigm argument, that emerging markets are experiencing sustained higher growth rates brought on by global acceptance of capitalism creating free markets that didn't exist. This growth and openness has allowed the massive pools of liquidity invested in developed economies, at ever lower returns given the 25+year secular decline in interest rates, to flow to emerging markets. The answer is somewhere in between, with the no argument being more relevant over the intermediate term and the yes side more important tomorrow and five years from now.

The problem with trying to come up with an answer is the emerging market are viewed generally through developed market glasses. It must be kept in mind that business practices, legal protections, investment diversity, and state involvement are usually quite different. The way investments are made in different regions of the world can vary, although with the opening of capital markets, they are becoming more similar. For example, direct investment used to be more common in Asia than Latin America, but that is changing. It is very difficult to make investments in many countries, China for example. Because the investment scope is limited, investors tend to put money to work in items that will give them market exposure, but allow for necessary liquidity. This provides a constant bid for investments that can easily be trading, propping up the market. However, it can be a small door if everyone exits at once.

Short of a global recession or commodity price correction, emerging markets in general are probably OK. Investors have become much at looking at individual circumstance rather than viewing them as a whole. There are exceptions, China for one. Chinese securities firms and banks hold many places in the top ten in market capitalization worldwide. This has a lot to do with domestic Chinese investors having few other options for there money, especially with inflation there above 6.5%. Twenty years ago, the largest securities firm by market cap was Nomura, now not in the top 15. But, remember where the Tokyo exchange was then.